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Take a contrarian bet on BHP

A weakened commodity price environment has put mining giant BHP Billiton in value territory - it's time to disregard the naysayers and bump up your exposure
October 2, 2014

With iron ore prices in retreat, a beefed-up environmental regime for Chinese coal imports and a major asset spin-off in the mix, is now really the time to boost exposure to mining giant BHP Billiton (BLT)? Well, contrary to the views of many City analysts, we think that the 10 per cent drop in the group's share price over the past month has opened up a temporary buying opportunity.

IC TIP: Buy at 1750p
Tip style
Value
Risk rating
Medium
Timescale
Long Term
Bull points
  • Low-cost producer
  • Improving capital discipline
  • Strong institutional support
  • Discount to historic multiples
Bear points
  • Commodity price falls
  • Iron ore market in surplus

BHP's shares now trade at a discount against a range of historic valuation multiples. And although these discounts aren't particularly lofty in comparison with some other resource plays within the sector, it should be remembered that the Anglo-Australian miner retains strong institutional support despite the vagaries of commodity pricing. A respectable dividend yield coupled with solid cover also helps limit volatility. As a result, the group's shares tend to trade within a relatively narrow price band. Indeed, over three years BHP's share price has ranged between a 16 per cent premium and a 9 per cent discount to the average. The recent pullback in its share price means the shares are now at the bottom of that range, and there are other enticing valuation metrics to consider.

BHP's enterprise value-to-cash profits (EV/Ebitda) ratio of 6.2 times is only marginally above a two-year low of 5.9 times, and is among the bottom 6 per cent of readings over the period. Meanwhile, the two-year average EV/Ebitda rating is more than a fifth higher than the current level at 7.5 times, with the two-year high at 8.9 times.

 

 

The low valuation against cash profits is a point especially worth considering given a forecast rise of 3 per cent in cash profits this year, followed by 6 per cent next year and another 5 per cent in the year to the end of June 2017. In addition, analysts at Investec Securities predict that BHP's free cash flow per share and dividend should increase by 10 per cent and 14 per cent, respectively, to the 2017 financial year-end. As a result, BHP's free cash flow yield is expected to move up from the current rate of 14.9 per cent to 16.4 per cent by the end of the period.

It's no secret that BHP, in common with industry rivals, is operating with a renewed onus on capital management. The new approach has been principally designed to keep a rein on overall unit costs and last year capital and exploration spending fell a third to $15.2bn (£9.3bn), resulting in a substantial $8.1bn increase in free cash flow. Group chief executive Andrew Mackenzie thinks that further annual savings of $3.5bn are achievable by the end of the 2016-17 financial year.

Of course, the resource giant's determination to drive down unit costs is being partly achieved through a large-scale expansion which has helped push iron ore markets into surplus just as demand growth has slowed in China. The end result is that prices are down by around 40 per cent on this time last year. And City analysts are now predicting that prices will average near their current level of $82 a tonne through 2015 (so far this year, it's averaged $103.11 a tonne).

While that's bad news on the face of it, it will squeeze high-cost producers out of the market and with BHP's break-even point at $49 a tonne - according to UBS AG - there is still plenty of headroom. And the core aim of increased production was to mitigate the impact of cyclical price variations through scale benefits.

Likewise, BHP's share price briefly came under pressure on recent news that China intends to dramatically reduce imports of lower-quality 'dirtier' coal. However, far from providing a negative beat for both BHP and the Australian coal industry, the Chinese crackdown on high-sulphur imports could provide a fillip for the local industry as Australia is generally a source of high-quality black coking coal.

BHP BILLITON (BLT)
ORD PRICE:1,750pMARKET VALUE:£97.3bn
TOUCH:1,749-1,750p12-MONTH HIGH:2,102pLOW: 1,715p
FORWARD DIVIDEND YIELD:4.7%FORWARD PE RATIO:11
NET ASSET VALUE:1,487¢NET DEBT:33%

Year to 30 JunTurnover ($bn)Pre-tax profit ($bn)Earnings per share (¢)*Dividend per share (¢)*
201270.523.9291112
201366.019.7210116
201467.222.2259121
2015*68.022.0248127
2016*70.923.4264133
% change+4+6+6+5

Normal market size: 1,000

Matched bargain trading

Beta:1.29

£1 = $1.63

*Investec Securities forecasts, adjusted PTP and EPS figures